Presentation by S P Dhal, Faculty Member, SPBT College Risk Management in Banks Live Interactive Learning Session [Module B]

What is Risk? Risk is the probability that the realised return would be different from the anticipated/expected return on investment. Risk is a measure of likelihood of a bad financial outcome. All other things being equal risk will be avoided. All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return.

What is Risk? The uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or un- favourable. The un-favaourable impact is ‘RISK’ of the business.

Anatomy of Bank Risk Non-Financial Risk Financial Risk Business Risk Strategic Risk Delivery (of Financial Services) Risk Balance Sheet Risk Operational Risk Legal Risk Reputational Risk

Balance Sheet Risk Credit Risk Concentration Risk Intrinsic Risk Market Risk Interest Rate Risk Liquidity Risk Currency Risk Commodity Risk

Interest Rate Risk Price RiskReinvestment Risk Yield Curve Risk Basis Risk Gap Risk

Risk in Traditional Sense Systematic Risks Affects all Industry/ All securities Non-controllable Non-diversifiable Unsystematic Risks Affects specific Industry/ Specific Securities Controllable Diversifiable

Risk in Banking Business Banking business is broadly grouped under following major heads from Risk Management point of view: 1.The Banking Book 2.The Trading Book 3.Off-Balance-sheet Exposures

The Banking Book All assets & liabilities in ‘banking book’ have following characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied Since assets & liabilities are held till maturity, their mismatch may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as ‘Liquidity Risk’.

The Banking Book Due to change in interest rates, assets and liabilities are subjected to interest rate risk on their maturities/re-pricing. Further, the assets side of the banking book generates credit risk arising from defaults in payment of interest and or installments by the borrowers. In addition to all these risk, banking book also suffers from ‘Operational Risk’.

The Trading Book The trading book includes all the assets that are held with intention of trading that are marketable. They are normally held for a short duration and positions are liquidated in the market. Trading Book assets include investment held under ‘Held for Trading’ category. They are subjected to Market Risk and are marked to market.

Off-Balance-Sheet Exposure Off-balance sheet exposure is contingent in nature- Guarantees, LCs, Committed or back up credit lines etc. A contingent exposure may become a fund-based exposure in Banking book or trading book. Therefore, Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, credit or default risk and operational risk

RISKS IN BANKING Risk is inherent in Banking Banking is not avoiding risks but managing it Risks in banking can be of Broadly 3 types: –Credit Risk –Market Risk –Operational Risk ALM addresses to Market Risks

Risk Management in Banks & Basel Accord –I, 1988 In 1988, Basel Committee on Banking Supervision, published a framework for a minimal capital requirement for credit exposure. The bank books were classified into 5 buckets i.e. grouped under 5 categories according to credit risk weights of zero, ten, twenty, fifty and one hundred percent. Assets required to be classified into one of these risk buckets based on the parameter of counter party. Banks required to hold capital equal to 8% of the risk-weighted value of assets. In India, the minimum capital requirement is 9% as decided by RBI.

1996 Amendment to include Market Risk In 1996, BCBS published an amendment to provide an explicit capital cushion for ‘Market Risk’ to which banks are exposed. Market Risk is the risk of adverse deviations of the marked-to-market value of the assets due to market movements as a result of change in interest rates, market price or exchange rate.

Basel II Accord- Need & Goals Linking of risks with capital in terms of Basel Accord I needed a revision for the following reasons: - Credit assessment under Basel I is not risk sensitive enough. ‘One Suit fit all’ approach was applied all types of entity with 100% risk weightage. - Risk arising out of operation were ignored though it has potential of affecting the bank’s survival.

Basel Accord II The Basel II Accord is based on three pillars: Minimum Capital Requirement Supervisory review process & Market discipline

Minimum Capital Requirement Three Basic Pillars Supervisory Review Process Market Discipline Requirements The New Basel Capital Accord

1.Minimum Capital Requirements- Credit Risk (Pillar One) Standardized approach (External Ratings) Internal ratings-based approach Foundation approach Advanced approach Credit risk modeling (Sophisticated banks in the future) Minimum Capital Requirement

Standardized Approach Provides Greater Risk Differentiation than 1988 Risk Weights based on external ratings Five categories [0%, 20%, 50%, 100%, 150%] The loans considered past due be risk weighted at 150 percent unless a threshold amount of specific provision has already been set aside by the bank against the loan Special treatment for ‘retail’ & ‘SME’ sectors The New Basel Capital Accord

Capital for Credit Risk- Internal Rating Based Approach: Three elements: – Risk Components [PD, LGD, EAD] – Risk Weight conversion function – Minimum requirements for the management of policy and processes – Emphasis on full compliance Definitions; PD = Probability of default [“conservative view of long run average (pooled) for borrowers assigned to a RR grade.”] LGD = Loss given default EAD = Exposure at default Note: BIS is Proposing 75% for unused commitments EL = Expected Loss

The New Basel Capital Accord Market Risk: (a) Standardised Method (i) Maturity Method (ii) Duration Method (b) Internal Models Method

The New Basel Capital Accord Capital Charge for Operational Risk- As in credit, three alternate approaches are prescribed: - Basic Indicator Approach - Standardised Approach - Advanced Measurement Approach

Capital Charge for Operational Risk- Basic Indicator Approach To begin with, RBI has advised bank to follow Basic Indicator Approach in India which is 15% of the average Gross Income over three year.

K BIA = [ ∑ (GI*  ) ] / n, Where K BIA = the capital charge under the Basic Indicator Approach. GI = annual gross income, where positive, over the previous three years  = 15% set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator. 15% set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator. n = number of the previous three years for which gross income is positive Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM investments.

New Basel Accord II: supervisory review process- Defines the role of supervisors with regard to capital adequacy Pillar II

New Basel Accord II: Market Discipline Disclosure requirements that allow market participants to assess key information about a bank’s risk profile and level of capitalisation. Pillar-III

Value at Risk VaR is defined as the predicted worst-case loss at a specific confidence level over a certain period of time assuming normal trading conditions. That means, we can incur loss a maximum of Rs. X (the VaR) over the next one week (time period) and, may expect with 99% confidence level (i,.e. it would be so 99 times out of 100).

Advantages of VaR It captures an important aspect of risk in a single number It is easy to understand It asks the simple question: “ How bad can things get? ”

(a) The daily return on the company portfolio follows a normal distribution so that a one-week VaR could be computed. (b) The one week VaR at the 99% confidence level is $5M. (c) With probability 95%, the company will not experience a loss greater than $95M in one week. (d) With probability 5%, the company will loose $1M or more in one week. Q. A Bank reports a one-week VaR of $1M at the 95% confidence level. Which of the following statements is most likely to be true?

Q. Risk Weight of 2.5% on Government Bonds is introduced to address: (a). Credit Risk (b). Operational Risk (c). Market Risk (d). Counter Party Risk

Q. Reserve Bank of India has advised Banks to build up an Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of their investments in the categories “Held for Trading” (HFT) and “Available for Sale” (AFS). The specification is to take care of following Risk. (a). Interest Rate Risk (b). Operational Risk (c). Credit Risk (d). None of above

Q. “Netting” is a method of aggregating two or more obligations to achieving a reduced net obligation. The benefits accrues from “Netting” is: (a). Reduced Credit Risk (b). Liquidity Risk (c). Systemic Risk (d) All of the above

Q. How is the risk of so-called catastrophic losses dealt with? (a). Through RAROC models. (b). Through VaR, preferably delta- gamma approach. (c). By proper Disaster Recovery Plan & Business Continuity Plan in place. (d). By mitigation, with reserves in capital.

Q. Money market funds are generally considered to have ______ interest rate risk,and______ default risk. (a). low; low (b). low; high (c). high; low (d). high; high

Q. The June 1999 Basle Committee on Banking Supervision issued proposals for reform of its 1988 Capital Accord (the Basle II Proposals). These proposals contained MAINLY: I. Settlement risk management II. Capital requirements III. Supervisory review IV. The handling of hedge funds V. Contingency plans VI. Market discipline (a). I, III and VI (b). II, IV and V (c). I, IV and V (d). II, III and VI

Q. If the default probability for an “A”- rated company over a three year period is 0.30%, then the most likely probability of default for the same company over a six year period is: (a). 0.30% (b). Between 0.30% and 0.60% (c). 0.60% (d). Greater than 0.60%

Q. Which of the following procedures is essential in validating the VaR estimates. (a) Back Testing (b) Scenario Analysis (c) Stress Testing (d) Once approved by regulators no further validation is required.

Q. Loans are securitized to: (a) Reduce credit concentrations. (b) Reduce regulatory capital. (c) Provide access to loan products for investors. (d) All of the above.

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